Has the Fed Found the Data It Has Been Looking for to Justify a December Rate Hike?
The stock market continued to grind its way higher last week, even as it traded off following Friday’s substantially weaker than expected September Employment Report, which led the market to finish the week with a stubbed toe. Candidly, following the missed relative to expectations results from restaurant company Darden (DRI), we were bracing for a weaker than expected employment print and we were not disappointed.
We expect to see further hurricane reverberations this week in economic data and the earnings reports to be had. We talked about some of this on last week’s Cocktail Investing Podcast as well as reviewed the growing number of 2017 holiday shopping forecasts that favor online and mobile shopping. We see that as confirming not only for our Connected Society investing theme, but for our position in Amazon (AMZN) on the Tematica Investing Select List.
On the Economic Front
Following last week’s economic smorgasbord, which we recapped for your reading pleasure in Friday’s Weekly Wrap, the coming week sees a far slower pace of economic data. Make no mistake, while the number of reports is smaller week over week, there are still a few doozies to be had this week. These include the inflation bearing figures in the September PPI and CPI reports. Over the last few months, the PPI report has not sparked a sense of rising prices, and excluding the rise in gasoline prices the other components of the monthly CPI report echoed the PPI readings.
As we discussed in last week’s Cocktail Investing Podcast, “Inflationistas” were harping on the surge in Prices component of the September ISM Manufacturing Report and odds are we will some confirming data this week. As we shared, that month over month jump was likely due impact of the hurricane trifecta that hit during September, and is more likely than not going to be transitory in nature. That said, this could be the data the Fed has been looking for to justify its expected December rate hike.
We’re likely to see some disruption in the September Retail Sales as the impact of all three hurricanes is felt. September auto & truck sales moved sharply higher for the month at all manufacturers, and odds are Hurricane Irma means another strong month is to be had in October. We’re likely to see other retail categories “thrown a bone” as consumers replace what was lost or destroyed. However, given the state of the consumer (rising debt, tepid wage growth, and generally under saved) this near-term bump in retail sales is likely to be a pull-forward in demand plain and simple.
Inside the monthly Retail Sales report, we’ll be looking for evidence of the accelerating shift to digital shopping as we soon enter the 2017 holiday shopping season. On last week’s podcast, we recap the several 2017 holiday shopping forecasts that have been published, and discuss the growing influence of digital shopping, especially mobile shopping.
On the Earnings Front
The trickle of corporate earnings reports we saw last week picks up some this week, but it’s still small potatoes compared to what will be unleashed beginning next Monday (Oct. 16). Among the reports to be had, we’ll be digging into comments from Barracuda Networks (CUDA) on recent cyber attacks and what they mean for our Safety & Security theme. While Delta Air Lines (DAL) likely saw some hurricane disruption, it’s comments on international travel trends will be fodder for our Rise & Fall of the Middle Class investing theme.
As we mentioned above, last week we parsed the 2017 holiday shopping forecasts, but we’ll look for further insight from Cashless Consumption contender Blackhawk Networks (HAWK) this week. Amid conflicting September economic data that we discussed in Friday’s Weekly Wrap, we’ll look to comments and guidance from JB Hunt Transportation (JBHT) to get a clearer view on the true speed of the economy. Finally, comparing results at Del Frisco’s Restaurant (DFRG) with the recent Retail Sales reports should reveal the resiliency to be had with our Affordable Luxury theme.
Each week we look for data points pertaining to our 17 investment themes, or as we call them Thematic Signals. These signals can be confirming or they can serve to raise questions as to whether a theme’s tailwinds are strengthening or ebbing. Be sure to check out the Thematic Signals section of our website to read more about these stories and others we publish throughout the week. Here are some of the highlights we saw this week:
Rise & Fall of the Middle Class
Nothing better than having an organization like Gallup issue confirming data for our Rise & Fall of the Middle-Class investing theme. While most tend to understandably focus on China and India given the size of their respective populations, Gallup's finding reminds us upward economic mobility is occurring in other emerging Asian economies. This target market expansion is poised to attract U.S. companies looking to offset waning growth in more mature economies that are contending with the falling middle-class as well as Cash-Strapped Consumer. Read More >>
We at Tematica have shared our view that Amazon (AMZN)is the innovator to watch as it continues to disrupt existing business models. Amazon is not always successful as evidenced by its flopping in the smartphone market, but like any true innovator they keep working at it and sometimes that means outflanking a competitor where they least expect it. Despite all the talk of Apple's (AAPL) CarPlay and Alphabet's (GOOGL) Android Auto, it's Amazon that continues to expand its footing in the automotive market with Alexa. As Alexa's reach is expanded from smart speakers by Amazon as well as third-party ones from Sonos, it is moving beyond that and penetrating the appliance and automotive markets with Apple and Alphabet yet to catch up. Once again, Amazon is out-innovating the disruptors, making Alexa an even stickier part of our lives with linkages to Nissan, BMW and others. Read More >>
Fattening of the Population
We have shared many a data point on the hidden costs associated with our Fattening of the Population investing theme. Recently the Center for Disease Control and Prevention reminded that us the vast majority of people do not realize the degree to which obesity and being overweight leads to cancer and other healthcare issues. We see this as proof positive of the pain point created by our Fattening of the Population theme, one that screams for solutions as simple adopting our Food with Integrity theme to ones that fit with our Disruptive Technology theme and the fountain of youth aspect of our Aging of the Population theme. We expect our Fattening of the Population theme to come to the forefront of the healthcare debate as people look to wrangle costs lower and adopt a more preventative posture to health issues. Read More >>
ETFs: The Importance of “Looking Under the Hood"
Written by: Doug Sandler, CFA, Global Strategist at Riverfront Investment Group
The growth of the ETF industry has been a boon to investors, providing access to new asset classes and time-tested investment strategies at a competitive cost. However, the industry’s rapid growth has also brought its own set of challenges with one of the biggest being how to ‘make sense of it all’.
With thousands of ETFs in existence and new offerings becoming available every day (see chart below), it has become increasingly important to thoroughly research an ETF before buying it. Most ETFs are not as alike as their naming conventions or category classification might imply. Only by ‘looking under the hood’ can an investor truly assess the unique features and risks that ultimately impact the performance of an ETF in varying economic environments.
Many of the investment professionals at Riverfront have been building ETF portfolios for nearly 15 years and we are fortunate to have a number of proprietary and third-party tools that enable us to easily identify and quantify the risks in every ETF we invest in. However, since these tools can be expensive and difficult to develop, we often see investors relying on simple points of comparison like expense ratios or size/trading volume when choosing between several ETFs.
This lack of in-depth analysis means that investors can be unknowingly comparing ‘apples’ to ‘oranges’ and making a purchase decision based upon which is cheapest or which is most popular. In this article, we share a framework to help compare ETFs and properly assess their key features and risks.
We believe that the three most important characteristics to consider when comparing ETFs are: 1. Universe Definition, 2. Selection Criteria and 3. Weighting Methodology.
1. Universe Definition:
Every ETF is built from a defined universe of stocks. A universe can be defined broadly, like all companies in the Wilshire 5000, or narrowly, like all biotechnology companies in the S&P 500. What a universe includes or excludes can have meaningful performance implications, and thus should be an important consideration when comparing ETFs. Below are a few examples of universe differences that are often overlooked by investors.
A. Europe Example: What one index provider defines as European companies may differ from the definition used by another provider. One important distinction is whether they are including companies that are members of the European Union (EU), or members of the European Monetary Union (EMU). The EU is comprised of 28 countries that have agreed to principals governing interactions including trade and immigration. The EMU, on the other hand, is made up of only the 11 countries that utilize the Euro as their common currency. A number of countries like Germany and France are members of both the EU and EMU; however there are a number of countries like the UK, Switzerland, and Norway that are members of the EU and not the EMU. The countries in the EU but not in the EMU represent nearly 50% of the EU index and their exclusion can be expected to impact an ETF’s performance. This difference may become increasingly relevant as the UK faces its own unique challenges navigating its exit from the EU (Brexit).
B. Emerging Market example: The two largest emerging market (EM) ETFs have one key difference, the inclusion of South Korea. South Korea is the 2nd largest country weighting in the emerging market index as defined by MSCI, currently representing roughly 15% of the index. The FTSE emerging market index, which is the index behind the largest EM ETF in the marketplace, does not consider S. Korea as an emerging market country and thus does not include it in its index. The dissimilar treatment of S. Korea can have material performance implications on the two ETFs, as it has so far in 2017, with S. Korea significantly outperforming other emerging market countries. Investors worried about escalating tensions with North Korea, or believe that these fears are overblown, need to consider these differences when choosing their EM ETF.
C. Technology Example: Some indexes define technology more broadly than others. A key area of differentiation is with regard to how they define Internet Retail. Some index providers classify these companies within the technology sector, while others view them as members of the consumer discretionary sector. Similar varied treatment can be found with regard to the media and the electric vehicle industries. With Internet retail, media and electric vehicles comprising a significant portion of some technology indexes, the performance implications can be profound. Those that believe companies in these industries represent the future of technology should consider an ETF that is built on a more inclusive index.
2. Selection Criteria:
The next characteristic to consider, in our view, is the ETF’s selection methodology. ETFs with a selection methodology based on criteria (i.e., ‘factors’) other than ‘market capitalization’ are often referred to as ‘Smart-Beta’. A factor is a characteristic like ‘share-price volatility’ or ‘dividend yield’ that is used to screen or rank securities within a defined universe. With over 2,000 listed ETFs, there is likely an ETF to satisfy the needs of even the most discerning ‘stock-picker’. An ETF’s selection criteria can be simple, utilizing just a few static factors, or sophisticated like those that employ dozens of variable factors.
A. Number of Criteria (Factors): Every selection methodology has the potential to introduce biases into an ETF that may not be entirely transparent or intentional. For example, an ETF that selects its constituents using a factor like ‘value’ will also likely impart significant sector overweights and underweights into the fund. Many “value”-based indexes, for example, are currently overweight financials and underweight technology and healthcare. Investors who are bullish on technology and bearish on financials should steer clear of value ETFs with these structural biases. A general rule of thumb is that ETFs that employ a small number of factors (four or less) tend to have more biases than those that have more complex factor selection methodologies. While there is nothing inherently wrong with a bias if it’s what an investor intended, it is important that those biases are known ahead of time and not a ‘surprise’ later. We like to say: ‘Every ETF has a bias, never make a purchase decision before you find it.”
B. Factor Definition: Selection methodologies can also vary in the way they define a factor. For example, the ‘value’ factor can be defined differently by different index compilers. One might use a company’s price/book ratio while another uses price/earnings or price/sales. To complicate things further, one provider may only include the constituents with the most extreme ‘value’ rankings and another might include a broader group of companies with attractive ‘value’ rankings. This can lead to significant cap, sector and industry weighting differences between two similar sounding ‘value’ ETFs. For example, as of 11/30/17, the two largest value ETFs as determined by ETFdb vary in their small and mid-cap exposure by ten percentage points. Just like you should not judge a book by its cover, it can be dangerous to judge an ETF by its name alone.
C. Static or Variable (Active): Active ETFs differ from traditional ETFs in an important way. Active ETFs do not follow an index and as a result have the flexibility to adjust their selection criteria, as opposed to traditional ETFs that follow indexes whose selection methodology is set at the time of the index’s inception. There are pros and cons to each methodology. One advantage of active ETFs is that they have the ability to evolve and adapt to a changing investment climate. Some might view this advantage as a disadvantage, since the ETF’s biases will be dynamic and less predictable. For example, an active US equity ETF that falls under a mid-cap classification one day, may become more large-cap focused three months later.
3. Construction/Weighting Methodology:
The third important differentiating characteristic, in our view, is the ETF’s weighting methodology. The weighting methodology not only has the potential to introduce additional biases, but can also dilute or amplify the selection methodology.
A. Capitalization Weighting vs Non-Capitalization Weighting:
- Size Bias: ETFs that utilize a market capitalization weighting scheme will tend to contain a size bias that favors large-caps, while a non-cap weighted methodology will tend to have greater exposure to mid and small-caps. This can be particularly important at various market stages. For example, it is not unusual for small and mid-caps to outperform in the early stage of a bull market due to their greater leverage to improving business conditions, while large-caps often outperform in a bear market when investors demand stronger balance sheets.
- Concentration Bias: Market-cap weighting methodologies can also introduce concentration risk to a portfolio, where a handful of securities comprise a significant portion of the ETF. A popular South Korean index, for example, is cap-weighted and dominated by a single company that comprises more than 23% of the index. Concentration issues can undermine an objective to diversify risk, particularly in higher risk areas like biotechnology or emerging markets. Ultimately, an unintended concentration bias can turn the ‘right’ idea into the ‘wrong’ outcome if not monitored closely.
B. Factor-Weighted: Factor-weighting methodologies assign the greatest weights to the stocks that have the highest factor scores. For example, the largest constituents in a factor-weighted momentum ETF will be the stocks displaying the strongest momentum. A factor-weighted ETF can be expected to perform differently than one that simply identifies the 100 strongest momentum stocks and weights them equally. Factor-weighting methodologies have the potential to amplify returns positively or negatively.
One could argue that buying an ETF is similar to buying an automobile. A car buyer rarely makes their purchase decision based solely on price. Instead they consider the vehicle’s design, drivetrain and safety features to determine if it meets their unique needs. In most cases, the decision to purchase an ETF should also not be made solely on the fund’s expense ratio, since there are likely other distinguishing features that will be more impactful to the fund’s performance. By understanding the construction and drivers of performance in an exchange-traded product, investors can minimize the potential for surprises down the road.
Important Disclosure Information:
The comments above refer to generally to financial markets and not RiverFront portfolios or any related performance.
Past results are no guarantee of future results and no representation is made that a client will or is likely to achieve positive returns, avoid losses, or experience returns similar to those shown or experienced in the past.
Information or data shown or used in this material was received from sources believed to be reliable, but accuracy is not guaranteed.
Exchange-traded funds (ETFs) are sold by prospectus. Please consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus and summary prospectus, which contains this and other information, can be obtained by calling your financial advisor. Read it carefully before you invest. As a portfolio manager and a fiduciary for our clients, RiverFront will consider the investment objectives, risks, charges and expenses of a fund carefully before investing our clients’ assets.
ETFs are subject to substantially the same risks as those associated with the direct ownership of the underlying securities owned by the ETF. Additionally, the value of the investment will fluctuate in response to the performance of the underlying index or securities. ETFs typically charge and/or incur fees in addition to those fees charged by RiverFront. Therefore, investments in ETFs will result in the layering of expenses.
Actively managed funds are subject to management risk. In managing a fund’s investment portfolio, the sub-advisor will apply investment techniques and risk analysis that may not have the desired result.
Diversification does not ensure a profit or protect against a loss.
Technology and Internet-related stocks, especially of smaller, less-seasoned companies, tend to be more volatile than the overall market.
Small-, mid- and micro-cap companies may be hindered as a result of limited resources or less diverse products or services and have therefore historically been more volatile than the stocks of larger, more established companies.
Investments in international and emerging markets securities include exposure to risks such as currency fluctuations, foreign taxes and regulations, and the potential for illiquid markets and political instability.
Beta measures volatility relative to a benchmark. A result greater than 1.0 implies that a security is more volatile than the benchmark; a result less than 1.0 suggests that the security is less volatile than the benchmark. Betas may change over time.
RiverFront Investment Group, LLC, is an investment adviser registered with the Securities Exchange Commission under the Investment Advisers Act of 1940. The company manages a variety of portfolios utilizing stocks, bonds, and exchange-traded funds (ETFs). RiverFront also serves as sub-advisor to a series of mutual funds and ETFs. Opinions expressed are current as of the date shown and are subject to change. They are not intended as investment recommendations.
RiverFront is owned primarily by its employees through RiverFront Investment Holding Group, LLC, the holding company for RiverFront. Baird Financial Corporation (BFC) is a minority owner of RiverFront Investment Holding Group, LLC and therefore an indirect owner of RiverFront. BFC is the parent company of Robert W. Baird & Co. Incorporated (“Baird”), a registered broker/dealer and investment adviser.
These materials include general information and have not been tailored for any specific recipient or recipients. Accordingly, these materials are not intended to cause RiverFront Investment Group, LLC or an affiliate to become a fiduciary within the meaning of Section 3(21)(A)(ii) of the Employee Retirement Income Security Act of 1974, as amended or Section 4975(e)(3)(B) of the Internal Revenue Code of 1986, as amended.
Index Definitions (You cannot invest directly in an index):
The Wilshire 5000 Total Market Index, or more simply the Wilshire 5000, is a market-capitalization-weighted index of the market value of all stocks actively traded in the United States.
The MSCI Emerging Markets Index captures large and mid cap representation across 24 Emerging Markets (EM) countries*. With 838 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.
The FTSE Emerging Index is a free-float, market-capitalization weighted index representing the performance of around 850 large and mid cap companies in 22 emerging markets. The index is derived from the FTSE Global Equity Index Series.
The MSCI Europe Index represents the performance of large and mid-cap equities across 15 developed countries in Europe. The Index has a number of sub-Indexes which cover various sub-regions market segments/sizes, sectors and covers approximately 85% of the free float-adjusted market capitalization in each country.
The S&P 500® is widely regarded as the best single gauge of large-cap U.S. equities. There is over USD 7.8 trillion benchmarked to the index, with index assets comprising approximately USD 2.2 trillion of this total. The index includes 500 leading companies and captures approximately 80% coverage of available market capitalization.
Copyright ©2017 RiverFront Investment Group. All rights reserved. 2017.298
This document is a general communication being provided for informational purposes only. It is educational in nature and not designed to be a recommendation for any specific investment product, strategy, plan feature or other purpose. Any examples used are generic, hypothetical and for illustration purposes only. Prior to making any investment or financial decisions, an investor should seek individualized advice from personal financial, legal, tax and other professional advisors that take into account all of the particular facts and circumstances of an investor’s own situation.
J.P. Morgan Asset Management is the marketing name for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide.
J.P. Morgan Asset Management and JPMDS are not affiliated with RiverFront Investment Group.
- 1 of 2154